Reasonable Compensation for S Corporation Shareholder-Employees

Over the past five years, a few widely
noted cases and multiple government reports have made
reasonable compensation a key tax issue for S
corporations. Two recent Tax Court opinions focusing on
reasonable compensation for S corporation
shareholder-employees provide important takeaways for
owners and practitioners by addressing common issues
surrounding distributions and loan repayments in the
context of reasonable compensation.

Glass Blocks Unlimited

In Glass Blocks
Unlimited,an S corporation made payments totaling $62,488 to
its sole shareholder over the two-year period at issue.
The company reported a portion of the payments as dividend
distributions and a portion as repayment of shareholder
loans. It did not report any compensation to the
shareholder, even though he worked more than 40 hours per
week and performed a majority of the roles within the
company. The IRS contended that all of the payments to the
shareholder represented wages and assessed a payroll tax
deficiency of $9,560 plus $3,605 in additions to tax under
Sec. 6651(a)(1) and penalties under Sec. 6656. In
disputing the tax and penalties, the S corporation raised
two arguments. Other S corporations with similar
circumstances should note the Tax Court's analyses of
these arguments.

The company agreed that the sole
shareholder was an employee during the years at issue.
However, in these years the shareholder transferred funds
to the company to sustain its operations during an
economic downturn. The company's first contention was that
a majority of the payments to the shareholder represented
a nontaxable repayment of these previous loans. The IRS
countered that the fund transfers were in fact capital
contributions and the distributions were wages rather than
repayments.

In making its decision, the Tax Court relied on the
facts and circumstances to determine the true nature of
the shareholder-employee's transfers to the company,
noting that the S corporation had the burden of proving that they were loans. The court
found that four major factors contradicted the company's
position: (1) There was no written agreement or
promissory note for the transferred funds; (2) the
shareholder did not charge interest; (3) the company did
not provide security for the loan; and (4) there was no
fixed repayment schedule. The significant takeaway from
this analysis is that for the transaction to be treated
as a loan rather than a capital contribution, the terms
of the transfer should reflect an unconditional
obligation for repayment, rather than one that is
entirely dependent on the company's ability to
repay.

The S corporation's next argument was
that reclassifying the entire distribution amount to wages
would constitute unreasonable compensation. The company
asserted that the shareholder-employee only worked
approximately 1,040 hours per year and the value of his
services did not exceed $15.25 per hour for a reasonable
annual salary of $15,860. The court noted that a fair
determination of reasonable compensation should take into
account several factors. These include the
shareholder-employee's role in the business, a comparison
of the salary to those of similar companies for similar
services, the nature and condition of the company, and
potential conflicts of interest.

In this particular
case, however, the Tax Court did not consider whether
these other factors supported the claimed hourly value for
the shareholder-employee's work. The court found that
there was strong evidence that the shareholder-employee
actually worked more than 2,080 hours per year. Thus, if
the S corporation's $15.25 per hour value for the
shareholder-employees was considered reasonable, his
annual salary for each year was at least $31,720. This
exceeded the amount actually transferred to the
shareholder either year, so the court determined that the
full amount of the distributions was compensation. In Fact
Sheet 2008-25, the IRS stated that the amount attributable
to compensation will not exceed the cash or property
actually directly or indirectly received by the
shareholder.

While this case did not delve deeply
into the factors that an S corporation should consider in
determining reasonable compensation, it does illustrate
that the IRS can and will reclassify not only dividend
distributions, but also purported loan repayments, as
employee compensation.

Sean McAlary Ltd. Inc.

In Sean McAlary Ltd.
Inc., the Tax Court evaluated expert witness
testimony from an IRS employee who performed a statistical
analysis to determine reasonable compensation for the
shareholder- employee. Despite reporting net income of
$231,454 and transferring $240,000 to the sole
shareholder, the S corporation did not report any wages or
file any payroll tax returns for tax year 2006. Based on
its expert witness's report, the IRS determined that of
the $240,000 received in 2006, $100,755 represented
reasonable compensation. As a result, the IRS issued the S
corporation a notice of determination for an employment
tax liability of $13,693 plus $7,667 in additional tax
under Sec. 6651(a) and penalties under Sec. 6656.

The S corporation asserted that the proper amount to be
reclassified as compensation should be $24,000, which was
the base amount provided for in a written compensation
agreement between the shareholder-employee and the
company. The court found that the agreement was not a
sound measure of the value of the shareholder-employee's
services because the shareholder-employee, as well as
being the sole shareholder of the S corporation, was also
its sole director. In those dual roles he represented both
himself and the company in writing the agreement, and thus
the agreement was clearly not the product of an
arm's-length negotiation. Further, the company did not
even follow the agreement, as it paid no wages to the
shareholder-employee, suggesting to the Tax Court that the
agreement "was forgotten, ignored, or adopted as mere
window dressing." Considering the company's sizable
profits, and noting that the sole shareholder held all of
the company's officer positions, worked 12-hour days
nearly year-round, performed all of the management
functions, and generated the majority of the company's
revenue, the Tax Court concluded that $24,000 was clearly
unreasonably low compensation.

In its discussion of
the IRS's proposed compensation amount, this case provides
insight into the Service's use of metric tools,
statistics, and surveys in determining reasonable
compensation. The IRS expert used the California
Occupational Employment Statistics Survey for 2006 to
determine the median hourly wage for the primary job
function of the shareholder-employee, concluding that the
appropriate hourly wage was $48.44 ($100,755 annually). In
support of this amount, which to a significant extent
depended on the S corporation's location and industry, the
expert used information from the Risk Management
Association (RMA) Annual Statement Studies. Focusing on
profit margin and percentage of compensation of
officers/directors/owners to net sales, the expert cited
RMA statistics to show that his proposed compensation
amount was reasonable based on the financial performance
and compensation rates of similar businesses in its
industry.

As it had in GlassBlocks Unlimited, the Tax Court noted that a number of factors go
into determining reasonable compensation for a
shareholder-employee. The IRS focused on comparative
wages and the profitability of similar businesses as the
dominant factors in this case. However, the Tax Court
did not simply accept the IRS's statistic-based
compensation determination without question. The court
noted that the sole shareholder's experience in the
industry was less than that of the average employee, the
company's operations were relatively modest, and a large
part of the company's financial success was due to
market conditions rather than the personal services or
expertise of the shareholder. Based on these factors,
the court determined that the IRS expert was aggressive
in his determination, and reduced the
shareholder-employee's reasonable compensation to $40
per hour ($83,200 annually).

This case
demonstrates that the IRS relies not only on subjective
qualities but also on concrete statistics in determining
reasonable compensation of shareholder-employees. S
corporations and their practitioners could benefit from
periodically comparing their compensation ratios to RMA
data and their salary amounts to industry-specific
guides.

Reflections

The potential for sole
shareholder S corporations to reduce their payroll tax
liability by minimizing compensation continues to be a
principal concern for the IRS and lawmakers. The immense
potential loss of employment taxes has been
well-documented, and, as talk of comprehensive tax reform
persists, discussions continue on whether to impose
self-employment tax on S corporation profits to prevent
this abuse. In the meantime, such companies can expect
increased scrutiny from the IRS regarding their
compensation of shareholder-employees. As demonstrated in
Glass Blocks
Unlimited and Sean McAlary Ltd.,
practitioners should be mindful of profitable S
corporations that make distributions but pay no or
relatively small shareholder compensation.

Even for
unprofitable companies like Glass Blocks Unlimited,
reasonable compensation may be an issue if the company
transfers funds to a shareholder-employee. The
considerable penalties and additions to tax, coupled with
the heightened focus on this issue, provide S corporations
and their tax advisers with ample incentive to ensure that
shareholder-employees are reasonably compensated.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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